Week 10 chapter notes
DepartmentEconomics for Management Studies
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Chapter 30 Inflation and Disinflation Notes
x inflation Æ rise in the average level of all pries; usually expressed as the annual percentage change in the Consumer Price Index
30.1 Adding Inflation to the Model
Why Wages Change
x three propositions about how changes in money wages were influenced by the output gap:
1. the excess demand for labour that is associated with an inflationary gap (Y > Y*) puts upward pressure on money wages
2. the excess supply for labour associated with a recessionary gap (Y < Y*) puts downward pressure on money wages
3. the absence of either an inflationary or a recessionary gap (Y = Y*) means that demand forces do not exert any pressure
x when real GDP is equal to Y*, the unemployment rate is said to be equal to the NAIRU, which stands for the non-accelerating
inflation rate of unemployment, sometimes known as the natural rate of unemployment, designated by U*
x the expectation of some specific inflation rate creates pressure for money wages to rise by that rate
x changes in money wages = output-gap effect + expectational effect
x rational expectations Æ the theory that people understand how the economy works and learns quickly from their mistakes so that
even through random errors may be made, systematic and persistent errors are not
From Wages to Prices
x net effect of the two forces action on wages—output gaps and inflation expectations—determines what happens to the AS curve
x actual inflation = output-gap inflation + expected inflation + supply-shock inflation
x if inflation and monetary policy have been constant for several years, expected rate of inflation will equal actual rate of inflation
x in the absence of supply shocks, if expected inflation equals actual inflation, real GDP must be equal to potential GDP
x constant inflation with Y = Y* occurs when the rate of monetary growth, the rate of wage increase, and the expected rate of
inflation are all consistent with the actual inflation rate
30.2 Shocks and Policy Responses
x demand inflation Æ inflation arising from an inflationary output gap caused, in turn, by a positive AD shock
x continued validation of demand shock turns transitory inflation into sustained inflation fuelled by monetary expansion
x supply inflation Æ inflation arising from negative AS shock that is not result of excess demand in domestic markets for FP
x whenever wages and other factor prices fall only slowly in the face of excess supply, the recovery to potential output after a non-
validated negative supply shock will take a long time
x monetary validation of a negative supply shock causes the initial rise in the price level to be followed by a further rise, resulting
in a higher price level than would occur if the recessionary gap were relied on to reduce factor prices
x to some economists, caution dictates that negative supply shocks should never be validated, to avoid wage-price spiral; others are
willing to risk validation in order to avoid significant, though transitory, recessions that otherwise accompany supply shock
x acceleration hypothesis Æ the hypothesis that when real GDP is held above potential, the persistent inflationary output gap will
cause inflation to increase
x according to the acceleration hypothesis, as long as an inflationary output gap persists, expectations of inflation will be rising,
which will lead to increases in the actual rate of inflation
Inflation as a Monetary Phenomenon
x there are three causes of inflation:
1. Cause 1: On the demand side, anything that shifts the AD curve to right will cause price level to rise (demand inflation).
2. Cause 2: On the supply side, anything that shifts the AS curve upward will cause the price level to rise (supply inflation).
3. Cause 3: Unless continual monetary validation occurs, the increases in the price level must eventually come to a halt.
x expectations-augmented Phillips curve Æ the relationship between unemployment and the rate of increase of money wages that
arise when the output-gap and expectations components of inflation are combined
x there are three consequences of inflation, assuming that real GDP was initially at its potential level:
1. Consequence 1: In short run, demand inflation tends to be accompanied by increase in real GDP above its potential level.
2. Consequence 2: In short run, supply inflation tends to be accompanied by decrease in real GDP below its potential level.
3. Consequence 3: When all costs and prices are adjusted fully (so that real GDP has returned to Y*), shifts in either the AD
or AS curve leave real GDP unchanged and affect only the price level.
x this leads to three important conclusions:
1. Conclusion 1: Without monetary validation, positive demand shocks cause inflationary output gaps and a temporary burst
of inflation. The gaps are removed as rising factor prices push the AS curve upward, returning real GDP to its potential
level, but at a higher price level.
2. Conclusion 2: Without monetary validation (MV), negative supply shocks cause recessionary output gaps and a
temporary burst of inflation. The gaps are eventually removed as factor prices fall, restoring real GDP to its potential and
the price level to its initial level.
3. Conclusion 3: Only with continuing MV can inflation initiated by either supply or demand shocks continue indefinitely.
x sustained inflation is everywhere and always a monetary phenomenon
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30.3 Reducing Inflation
The Process of Disinflation
x disinflation Æ a reduction in the rate of inflation
x reducing sustained inflation quickly incurs high costs for short period; reducing it slowly incurs lower costs but for longer period
x stagflation Æ simultaneous increase in inflation and reduction in output (or its growth rate) caused by upward shift of AS curve
x expectations can cause inflation to persist even after its original causes have been removed; what was initially a demand and
expectational inflation due to an inflationary gap becomes a pure expectational inflation
x how long inflation persists after the inflationary gap has been removed depends on how quickly expectations of continued
inflation are revised downward
The Cost of Disinflation
x the cost of disinflation is the loss of output that is generated in the process
x sacrifice ratio Æ the cumulative loss in real GDP, expressed as a percentage of potential output, divided by the percentage-point
reduction in the rate of inflation
30.1 Adding Inflation to the Model
x Sustained price inflation will be accompanied by closely related growth in wages and other factor prices such that the AS curve
is shifting upward. Factors that influence shifts in the AS curve can be divided into two main components: output gaps and
expectations. Random supply-side shocks will also exert an influence.
x Inflationary output gaps tend to cause wages to rise; recessionary output gaps tend to cause wages to fall.
x Expectations of inflation tend to cause wage increases equal to the expected price-level increases. Expectations can be backward-
looking, forward-looking, or some combination of the two.
x With a constant rate of inflation and no supply shocks, expected inflation will eventually come to equal actual inflation. This
implies that there is no output-gap effect on inflation—that is, real GDP equals its potential level.
x Constant inflation of 2% per year is shown graphically in the macroeconomic model by the AD and AS curves shifting up by 2%
per year, keeping real GDP equal to Y*.
30.2 Shocks and Policy Responses
x The initial effects of positive demand shocks are a rise in the price level and a rise in real GDP. If the inflation is unvalidated,
output tends to return to its potential level while the price level rises further (as the AS curve shifts upward). Monetary validation
allows demand inflation to proceed without reducing the inflationary gap (AD curve continues to shift upward).
x The initial effects of negative supply shocks are a rise in the price level and a fall in real GDP. If inflation is unvalidated, output
will slowly move back to its potential level as the price level slowly falls to its pre-shock level (AS curve slowly shifts down).
Monetary validation allows supply inflation to continued in spite of a persistent recessionary gap (AD curve shifts up with
x If the Bank of Canada tries to keep real GDP constant at some level above Y*, the actual inflation rate will eventually accelerate.
In our macro model, in the absence of supply shocks, constant inflation is only possible when there are no demand pressures on
inflation—that is, Y = Y*.
x Aggregate demand and supply shocks have temporary effects on inflation. But sustained inflation is a monetary phenomenon.
30.3 Reducing Inflation
x The process of ending a sustained inflation can be divided into three phases.
1. Phase 1 consists of ending monetary validation and allowing the upward shift in the AS curve to remove any inflationary
gap that does exist.
2. In Phase 2, a recessionary gap develops as expectations of further inflation cause the AS curve to continue to shift
upward even after the inflationary gap is removed.
3. In Phase 3, the economy returns to potential output, sometimes aided by a one-time monetary expansion that raises the
AD curve to the level consistent with potential output.
x The cost of disinflation is the recessionary (output loss) that is created in the process. The sacrifice ratio is a measure of this cost
and is calculated as the cumulative loss in real GDP (expressed as a percentage of Y*) divided by the reduction in inflation.
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